Solid performance

CLI started as Centrale del Latte di Torino (CLT), a milk supplier/distributor in the Turin area. Over time, the company extended its reach to the whole Piedmont region, where it is market leader, and subsequently added two more regions (Veneto and Liguria) in Northern Italy. In 2016 it merged with Centrale del Latte di Firenze, Pistoia e Livorno (CLF), adding Tuscany as a new region, and the enlarged entity was renamed Centrale del Latte d’Italia (CLI). The main focus remains milk, but over the years the company has added long-life and extended shelf-life (ESL) milk, fresh and long-life cream, yoghurt and fresh cheeses. More recently, it has distributed fresh pasta, eggs and prepared salads.

The company was founded in 1950 but largely remains a family-owned business. The largest shareholder is Finanziaria Centrale del Latte di Torino, which is controlled by the CLT founding families and in which the municipality of Turin owns a 20% stake. Another shareholder is Lavia, which is also owned by one of the founding families.

We calculate a fair value based on our DCF model of €3.30, which represents 2% upside. The main sensitivities to our forecasts and valuation are outlined below. In the longer term, the company is trying to diversify away from liquid cow’s milk, and into fresh produce and export markets for long-life milk. These are more attractive and profitable markets.

As an alternative to our DCF valuation, we look at CLI’s key metrics versus the peer group. We calculate that CLI now trades on 198x 2018e P/E and 13.8x 2018e EV/EBITDA. The P/E is inflated due to the relatively elevated debt level in the short term associated with the CLF acquisition, and hence the high interest costs. For 2019, these ratios fall to 51.4x and 13.0x respectively. On EV/EBITDA, CLI trades at a premium of 40% to the average of our peer group of dairy processors.

Financials: Capital investment dents cash flow

The Q118 results demonstrate the company has started the year well, despite the challenging domestic political and economic environment. That said, we expect comparatives to get tougher for the rest of the year, as we start to lap the price increases implemented during Q217. We therefore leave our forecasts unchanged at this stage. Net debt remains high, at €62.4m at December 2017 (and €69.1m at 31 March 2018). Given management’s plans to upgrade the Turin plant, we forecast net debt of €67.8m at end FY18, which equates to 8.7x net debt/EBITDA coverage, although it declines to 7.8x by FY21.

CLI’s key sensitivities include:

CLI is the third-largest dairy producer in Italy, after Parmalat and Granarolo. The company has a strong base in fresh milk, UHT milk and yoghurt. It has also diversified into branded fresh food products, with ranges of eggs, cheese, pasta, vegetables and ready-to-eat salads, and over the last few years it has also successfully launched non-dairy milk drinks such as rice, soy and oat milk. CLI’s key differentiating factor vis-à-vis its larger competitors is that it is a regional rather than a national player, as it operates in four main regions in Italy. We illustrate the breakdown of revenues by category and by geography in Exhibit 1 and 2 below.

Although CLI is significantly smaller than Parmalat and Granarolo, it is a regional champion, with leadership positions in the regions in which it competes. CLI has five factories, which are all well invested with the latest technology for the production, treatment and packaging of its products. The Turin plant is scheduled for an upgrade from 2018, with a focus on increasing efficiency on the logistics side, while the legacy CLF business is due to be migrated to the existing SAP platform.

CLI has created its own strong local brands to support its portfolio. Over the past three years, CLI has set its sights on international expansion: it started exporting UHT milk to China, and also signed an agreement with a distributor for the UAE, Kuwait, Saudi Arabia and Oman. Last October it signed a deal with Alibaba to accelerate its push into China.

The merger with CLF was large (CLF sales were c €85m in 2015 vs CLT’s sales of €97m), and we expect it will take a few years for the integration to be fully complete. Nevertheless, we believe more acquisitions are likely in future as the business continues to grow and the strategy to diversify and to enhance scale continues.

The Italian fresh milk and extended shelf-life (ESL) market was worth €543m in 2017 (source: IRI Infoscan Hypermarkets + Supermarkets) but was highly localised, with different players in different regions of Italy. While fresh milk typically lasts a few days before souring, ESL milk lasts for up to a month, but still requires refrigeration. Milk brands tend to be local or regional, and indeed consumers are used to buying milk brands from their own local province or region. There has been some degree of consolidation, with Parmalat and Granarolo emerging as the two leading players on a national scale, both with c 20% market share, but even they use several local brands in addition to their main brand (eg Centrale del Latte di Roma and Centrale del Latte di Milano, respectively). A significant proportion of milk in Italy is bought on a regular basis, and hence in local shops rather than in supermarkets or hypermarkets. This also affects distribution, and tends to favour local and regional brands.

The market has steadily declined over the last few years, mainly as a result of volume declines. The economic crisis in Italy caused consumption to fall across the board in the consumer space, and more recently a fashion for vegan and dairy-free diets has also caused a shift in consumer behaviour, which has led to volume declines. CLI has been gaining share in the regions in which it operates, thanks to the strength of its brands.

The Italian UHT milk market was worth €831m in 2017 (Source: IRI Infoscan Hypermarkets + Supermarkets). UHT milk is ultra heat-treated and hence is an ambient product with a shelf life of around three months. The ambient nature of the product means it is more widely bought as part of a bigger shopping basket and hence distribution is more skewed towards the mass retail channel. Promotion is much more prevalent in the UHT segment, although over recent years volumes have suffered for the same reasons as fresh milk, namely the economic crisis and the consumer shift away from dairy consumption. 2017, however, saw a stabilisation in the market, with value flat vs 2016. CLI’s market share is small at national level, but improves in its key markets.

In 2014 CLT began exporting UHT milk to China, and in October 2017 it announced a strategic partnership with Alibaba. Volumes remain small, but this could present an interesting growth opportunity. In 2015 CLT signed an agreement with a Dubai-based distributor.

The Italian yoghurt market is dominated by the major players, with Danone, Muller and Yomo/Granarolo making up 50% of the market. CLI is a small player at both national and regional level. With deep-pocketed multinational competitors on the scene, CLI cannot compete on the R&D front with new products, but it can react quickly to new launches given its smaller size, and has been successful in tapping into the market for lactose-free/soy-based products. The market remains competitive and dominated by price promotions by the multinationals. CLI chooses not to compete on price, as it recognises it does not have the same scale as the major players, and hence in 2017 the division underperformed.

This segment accounted for 3% of sales in 2017 and encompasses a range of ready-washed, dried and often pre-mixed salads. These products have been developed for the local, more traditional trade mentioned above, where a lot of fresh milk is still bought. These local shops do not have the logistics of the larger food retail chains, and hence rely on more regional fresh produce. Due to the relatively short shelf life of both fresh milk and prepared salads, CLI can leverage some of its fixed costs and has added the prepared salads line to enhance its offering. The offering has been successfully introduced across the CLF platform, demonstrating management’s plans for revenue synergies and cross-distribution are coming to fruition. With the recent tougher economic backdrop, however, this segment has experienced some softening as consumers have gravitated towards buying traditional salads (unwashed and not pre-mixed), which are significantly cheaper.

CLI launched a soy milk in Q213, and followed this with the launch of a rice milk in Q415. It launched an oat milk during 2016. Dairy-free milk is proving successful given the trend in Italy for vegan and dairy-free diets. Although the segment is small, growth continues to be impressive.

This segment acts as a by-product of the fresh packaged milk business: CLI’s contracts with its milk suppliers stipulate that CLI will buy all the milk produced by the farmer. This obviously changes daily but the main variation is due to seasonality. In addition, the volume of milk required by the fresh packaged milk business can have its own (separate) seasonal variations. Any excess milk, therefore, is sold on as bulk milk and cream to local businesses, mainly cheese- and butter-making businesses and ice cream shops or factories. The segment is very small (it accounted for 2% of sales in 2017), but is subject to wide swings as it is dependent on spot pricing.

This includes a diverse range of fresh products, spanning from fresh cheese to eggs, packaged fresh pasta and pesto sauces, eggs and pre-sliced and packaged cured meats. The strategy here is the same as for the prepared salads segment, so the products have been developed for the local shops. More recently, CLI has also started to produce branded products for major players under co-packing agreements, and private label products for major European retailers. The segment accounted for 27% of sales in 2017.

CLI’s key sensitivities include:

In 2016, Centrale del Latte di Torino (CLT) executed a merger by incorporation with Centrale del Latte di Firenze, Pistoia e Livorno (CLF), and the new entity was named Centrale del Latte d’Italia (CLI). This became Italy’s third-largest dairy producer. The transaction was highly complementary as the two businesses had leading market shares at the regional level in their respective areas, and operated in similar channels. The integration is not yet complete as the legacy CLF business is due to be migrated to the existing SAP platform during FY18. The enlarged entity reported its first full financial year in March, however, and the management is already looking ahead.

The management has identified several growth opportunities:

In order to remain competitive and retain production efficiencies, management is continuously appraising the group’s manufacturing footprint and capabilities. The logistics for the Vicenza plant have been upgraded and fully automated, while the upgrade of the manufacturing and production side is scheduled for 2018. The Turin plant is due for an upgrade during 2018, with both manufacturing and logistics being improved, and the latter being fully automated.

CLI’s share price performance has underperformed the FTSE MIB on a three-month and six-month basis, although the shares have performed broadly in line on a 12-month basis. On 2019 estimates, CLI trades on a P/E of 50.4x and EV/EBITDA of 13.0x. The P/E multiples are inflated due to the high level of debt following the merger, and hence the high interest costs.

On EV/EBITDA, CLI trades at a premium of c 40% to the average of our peer group of dairy processors, although we note that the companies in our peer group are much larger than CLI.

Our DCF is based on our (unchanged) assumptions of a 1.5% terminal growth rate and 3% terminal EBIT margin. Our WACC of 5.8% is based on an equity risk premium of 4.5%, a borrowing spread of 5% and beta of 0.9. Below, we show a sensitivity analysis to these assumptions and note that the current share price is discounting a terminal growth rate of 1.5% with a terminal EBIT margin of 3% (which compares to CLT’s pre-merger reported EBIT margin of 2.7% in 2014 and 1.6% in 2015).

In revenue terms, we see milk and basic dairy products as a mature category with stable or slightly declining volumes, and pricing driven mainly by the fluctuations of the underlying commodity (ie milk). We forecast 0.8% revenue CAGR translating into 6.5% EBITDA CAGR in 2017-20. We forecast some improvement in the underlying gross margin and EBITDA and EBIT margins. In particular, we have assumed 30bp EBITDA margin improvement in FY18, followed by 20bp improvement in FY19 and FY20, although fluctuations in raw material costs could affect our forecasts. The CLF merger was margin-enhancing given CLF’s higher base, and we expect the FY18 margin to see some benefit from the price increases put through during Q217. The benefit will fall away during FY18 and hence our forecast for FY19 and FY20 margin expansion falls to 20bp. In the long term, we assume the margin settles at our 3% terminal EBIT margin assumption (see our DCF valuation section).

We expect net finance costs to remain broadly flat over the forecast period. The group successfully completed a €15m bond issue during the latter part of FY17, which allows it to diversify its sources of debt. We note the terms were attractive, with a 3.25% coupon. Management has indicated that capex levels are likely to remain elevated as the Turin plant is modernised. We forecast that the operating cash flow will be largely reinvested in capex, hence debt will reduce slowly. In the longer term, however, we expect capital expenditure to normalise at much lower levels, given the business has relatively low top-line growth and is not overly capital-intensive.

We expect the tax rate to be 35% in underlying terms. It is bound to vary year-on-year depending on any exceptionals and also subject to rebates, but management guidance is for a long-term rate of c 35%.

Fluctuating commodity costs are an issue for all food manufacturers, and this is particularly the case for food that is relatively unprocessed such as fresh milk. Earnings are therefore likely to be more volatile due to changes in the raw milk price.

We have trimmed our dividend forecast for FY18-20 to €0.04 from €0.06 (as there was no dividend in FY17), as the company prioritises deleveraging. We believe management is more likely to reinstate a dividend at a lower level, to reflect the increase in number of shares as a result of the CLF merger (from 10m to 14m shares), leading to the estimated dividend-related cash outflow of €600,000.

The reduction in our dividend forecast causes a reduction in interest charge forecasts, and hence an upgrade to our EPS estimates. Our FY18 forecast moves up by 6% and our FY19 forecast by 2%.

The Vicenza plant improvements are now complete and the packing lines and logistics there are now fully automated. The Turin plant is still undergoing an upgrade, and it is a staged process, with the upgrade of the pasteurisation phase and new tanks (completed during FY17), the automation of the logistics side (currently ongoing), and an upgrade of the production lines (FY20). On the CLF side, the legacy CLF business is due to be migrated to the existing SAP platform during FY18. This results in elevated levels of capital expenditure in the medium term, with management expecting these to normalise again by 2020. This will depress free cash flow generation in the medium term and we forecast net debt to increase marginally over the period. Following the investment, the business should be better placed to compete in a challenging environment.

Although CLI has an elevated level of debt vs its market cap (c 130%), within the consumer staples universe it is an efficient capital structure. The group’s bond issue during Q417 allowed it to diversify its sources of debt. The debt maturity profile is adequate and relatively well balanced, with 34% of debt maturing within one year as of 31 December 2017 and 24% of debt with a term over five years.

The environment was extremely tough in the quarter, as the economic and political climate was very uncertain as a result of the general elections in Italy and there being no clear winner. Consumers generally remained cautious during Q118.

Raw materials witnessed a mixed picture during the quarter, with liquid milk prices starting to ease, while cream and butter prices continued to increase.

The yoghurt business had a tough start to the year. The overall yoghurt market was under pressure in Q1, and CLI’s business in particular suffered from increased promotional activity by the competition, which caused a loss of volume and market share. As a reminder, yoghurt only accounted for 5% of sales in FY17 so, although continued weakness is a concern, the size of the business is relatively small.

Q1 gross margins were up sharply (18.4% vs 16.4% in Q117) and this was mainly driven by the price increases implemented during Q217. Labour costs were down 20bp and EBITDA margins were up an impressive 220bp to 3.8% in Q118. We leave our underlying forecasts unchanged at this time, as it is still early in the year, and comparatives will get tougher as we start to cycle the price increases implemented during 2017. We trim our dividend forecast from €0.06 to €0.04 as we believe management is more likely to reinstate a dividend at a lower level, which reflects the increased number of shares following the CLF transaction. This results in lower interest expenses and hence an upgrade to our EPS forecasts.